Section 2: Flexible versus Fixed Currency Exchange Rate Systems

Most countries allow their currencies to fluctuate in value relative to foreign currencies. The currencies will fluctuate based on demand and supply forces, similar to demand and supply changes in the market for products. An increase in the demand for housing will increase the value (price) of houses. Similarly, an increase in the demand for the Australian dollar will increase the value (price) of the Australian dollar.

Depreciation and Appreciation

Depreciation and appreciation are changes in the values of currencies within a flexible exchange rate system.

If the supply of dollars increases, or the demand for foreign currencies increases relative to the demand for the dollar, then the value of the dollar falls. We say that the dollar depreciates.

If the demand for dollars worldwide increases, then the value of the dollar rises. We say that the dollar appreciates.

Example 1

Before U.S. dollar depreciation:
$1 = 100 yen

After U.S. dollar depreciation:
$1 = 95 yen

=

Fixed Exchange Rate System

Some countries prefer to keep their currency values fixed relative to other foreign currencies. For example, if 100 units of a foreign currency exchange for $1, and the two countries decide to keep their currency values fixed for a period of time, we speak of a fixed, or pegged, exchange rate system. Through most of the 1990s China kept its currency fixed relative to most foreign currencies. Today China lets its currency fluctuate, even though the Chinese government still influences the rate at which it lets its currency fluctuate. No major industrial countries use a fixed exchange rate anymore in today’s world economy.

Devaluation and Revaluation

In a fixed exchange system, if after a certain period of time, the government decides to “fix” its currency at a higher or lower value, then we speak of revaluation or devaluation respectively.

Example 2

Before devaluation:
$1 = 2 PHP (Philippine Peso)

After devaluation:
$1 = 1.5 PHP

Advantages and Disadvantages of Fixed Exchange Rate Systems

In a fixed exchange rate system, the currencies are fixed for a certain period of time (for example, 6 months, or a year). An advantage for importers and exporters is that there exists more certainty for import and export businesses, tourists, or anyone else engaging in international trade, in knowing what the currency values are within this period of time. A disadvantage of a fixed exchange rate system is that the currencies usually do not have their true market value. Therefore, surpluses or shortages occur.

Advantages and Disadvantages of Flexible Exchange Rate Systems

In a flexible exchange rate system currency values change on a daily basis. The disadvantage is that this creates uncertainty for importers and exporters when it comes to planning for future trades. Note, however, that buyers and sellers of currencies can “hedge” against (protect themselves from) fluctuating exchange rates. If a U.S. business needs 1 million Japanese yen 2 months from today, then it can go to the currency futures market and buy the Japanese yen at a rate agreed upon today. This way, they fix the value of the currency they buy or sell for a certain period of time. Futures markets can, therefore, provide certainty regarding the future value of the currency even in a flexible system. Most economists, therefore, prefer a flexible exchange rate system over a fixed exchange rate system, because a flexible exchange rate system has the following advantages:

The currency has its true market value.
The value is determined by the supply and demand of suppliers and buyers. If buyers place a high value on a currency, its demand increases and the value of the currency increases, and vice versa.

There are no long-term surpluses or shortages of the currency.
The market will always correct short-term surpluses and shortages by allowing the value to fluctuate.

No government central bank interference is necessary, and therefore no central bank losses occur.
In a fixed rate system, a central bank is forced to intervene in order to keep the rate fixed. These currency manipulations are costly, especially after a devaluation or revaluation of the fixed rate. If the market demand for dollars increases, then the market price of the dollar increases. In a fixed system, the government does not allow the market price to rise, and a shortage of the dollar occurs in the market. Speculators then anticipate that at some point in the future, the governments will increase the fixed value (revaluation). This expectation further increases the demand for the dollar. Eventually the pressure on the dollar becomes so strong that the governments, indeed, do revaluate (increase) the value of the dollar. Before the revaluation, the central banks had been purchasing the weaker currency and selling the stronger currency in an effort to avoid shortages and surpluses. After the revaluation of the stronger currency, the central banks experience significant losses due to the decrease in the value (devaluation) of the weaker currency they had been purchasing.